• Active funds have enjoyed a revival in 2017
• A collapse in asset price correlation has made it easier for active funds to outperform
• A reduction in geopolitical concerns aids falling correlation but this may not be sustainable
After a period of underperformance, active investment strategies are on the up – for now at least.
A report by Bernstein found that its sample of European fundamental portfolio managers had on average beaten their benchmarks (after considering fees) by 3.6 percentage points up to August 2017. In 2016, it had lagged the benchmark by 6 percentage points, before fees.
Although the report focused on Europe, the trend was global, according to Bernstein.
This news is a long time coming for active managers. Indeed, at the start of 2017, some sounded the death knell for active managers, noting that over a decade 83% of US-based active funds had failed to beat their benchmarks.
Bernstein’s report concludes that this has been driven by falling factor and stock correlations: “Broadly, low intra-sector correlations seem to come hand in hand with higher return dispersion, with both summing to a rich opportunity set for alpha generation within the sectors that boast both.” The connection is logical: it is hard to outperform if everything moves in lockstep.
Alla Harmsworth, head of European quantitative strategy at Bernstein, says: “The correlation first began to break down between different groups of stocks, and then within the groups themselves.” The research confirmed that the effect was persisting.
This trend has been accompanied by a rise in volatility. Harmsworth explains: “Stock correlations and the VIX [an index measuring implied volatility using a range of S&P 500 index options] tend to spike contemporaneously.” At first glance, this seems to be a classic ‘good news/bad news’ scenario: while it is good to have dispersal of returns to allow the opportunity for outperformance, investors dislike volatility. However, explains Harmsworth, “one shouldn’t worry about volatility increasing, as long as it’s not a sudden and sharp spike. Historically, volatility tends to rise after profit share peaks. As volatility peaks over the cycle, correlations begin to fall.”
Explanations for this correlation collapse have ranged from the reduction of quantitative easing (QE) to the election of President Trump. Harmsworth says the latter is unlikely, the waning of the ‘Trump rally’ notwithstanding, given the effect started before the election.
Valentijn van Nieuwenhuijzen, CIO at NN Investment Partners, is not convinced that the US pulling back from QE explains the return of fundamentals: “While the US Fed has stopped buying securities, it hasn’t yet begun to sell them, and the European Central Bank and Bank of Japan are still buying. Plus, it only has a secondary effect on equities, as this is a fixed-income buying programme.”
It seems an explanation is not to be found within geopolitics, but with these concerns receding. Harmsworth says: “This tends to happen during a more benign macro-environment, as it is at present, excepting the obvious issue of North Korea. In such times, market participants are less distracted by the noise and can refocus on fundamentals.”
This begs the question: how long can this last; is the assertion of fundamental factors hostage to the fortunes of global politics?
It seems the correlation breakdown is a more embedded trend. According to Harmsworth, “these effects persist for about 12 months forward, so that bodes well for active managers”.
That news is good for the active community. Passives reportedly attracted assets quicker than active funds in 2016 on the back of concerns about high fees and disappointing performance. Bernstein suggests that this may turn, with a “glimmer” of inflows into European funds. Could investors play this trend by reallocating to active managers?
That is inadvisable, says Nieuwenhuijzen. He says that seeking advantage from this cyclical phenomenon only makes sense if investors believe they have an edge over active managers in timing the market: “Trying to take advantage of the cycle between passive and active only makes sense if institutional investors believe they have the ability to time the market in the same way as they would, for instance, between value and growth stocks.” Instead, he advises, “it seems a more sensible approach for institutional investors to use active managers where they think there is good evidence of them being able to add value, combined with passives where they believe it to be more challenging.”
Jim Rowley, senior investment strategist at Vanguard, argues this research does not challenge passive investment strategies. Indeed, he says, the identification of ‘active’ gives a one-sided view of how active investment works: “While active funds may appear as outperforming, it’s important to remember that the securities bought by an outperforming fund were sold to them by someone else, whether that be a pension fund, a separate account or another subset of active investment. Active management is not solely defined by Ucits funds.”
While maybe true, such funds – or segregated accounts run on the same principles as pan-European Ucits funds – are how pension funds usually access active management.
Overall, it seems that the outperformance of passives has had one positive effect on the active industry, and that is to provide pressure on costs.
“The outperformance of passives has put pressure on active managers to price more competitively,” says Nieuwenhuijzen. Active managers may be able to justify juicy charges when they are beating the market, but its harder to ask for fees in excess of passives when underperforming them.
Rowley argues: “Investors, very much like any other consumer, have driven the market by making judgments on quality and cost. Institutions have recognised the impact of cost on performance, particularly when compounded over time.”
He emphasises “there is no research that shows premium price equating to premium performance”.
Nieuwenhuijzen counters that “the real issue isn’t charges per se, but total returns after charges”.
It is important to note that the research focuses on the sample’s average return. Funds that allocate to active managers say they can select above that average. Others remain cautious about their ability to achieve this with a consistency that justifies the fees.
But for now, it seems that by looking at the average, active management may enjoy a revival.